Over the last decade or so, telcos in developed markets have kept investors happy largely by operating like well-run utilities and paying steady dividends. It was therefore big news when several major European telcos—including Telefónica, France Telecom-Orange, Telecom Italia, and KPN—recently announced in quick succession that they would be forced to reduce payments to shareholders. There was no mystery, however, about why the companies had come under financial pressure. Among the developments cited in media accounts:

Tough competition in most major markets, exemplified by the mobile price war that broke out in France following the arrival of low-price operator Free Mobile. Free Mobile offers unlimited mobile service for just €19.99 per month.

Rapid erosion of telco revenues by so-called over-the-top, or OTT, services. Telecom operators lost $13.9 billion in SMS revenues in 2011 because of social messaging services, according to market researcher Ovum. Researchers at Informa calculate that every 10 percent increase in smartphone use in Western Europe could cost operators $1.19 billion in voice and messaging revenues.

The need to invest tens of billions of dollars over the next decade to build next-generation networks—even as the telcos face continued regulatory pressure to keep tariffs low.

With signs of upheaval so obvious, the sudden course change on shareholder payouts might have led a casual observer to wonder if telco executives had somehow been caught napping. The reality, of course, is quite different. They are far more likely to be sleeping too little than too much.

The predicament keeping them awake at night is easy to state but hard to solve: How can telcos respond to the nimble, specialized competitors attacking simultaneously on several fronts? The tasks at hand range from figuring out how to ride the wave of innovation in OTT services to tailoring service offerings for different customer segments to efficiently managing large networks in multiple locales. Pulled in all these directions, traditional telco operating models that were shaped in an era of government-owned monoliths are showing signs of severe strain. (See Exhibit 1.)

Meeting today’s varied challenges calls for agility—but companies are hamstrung by complexity. It calls for lowering costs further, but traditional cost-cutting opportunities have reached their limit. It calls for capturing synergies in international operations, but apart from greenfield situations, telcos haven’t yet been able to do that. Most fundamentally, it means facing up to the hard choices presented by the fracturing of the sector into four distinct subsectors, each with very different business characteristics and economics.

If incumbent telcos are to survive in this new landscape, they have no choice but to re-invent themselves. We believe they have only three to five years to accomplish this. In our August 2010 report The Future of Telecommunications, we described the different strategic subsectors in which telcos can hope to play. The clear message of the recent dividend crunch—and of the negative reaction from financial markets—is that the telcos urgently need to choose their battles and get on with the transformation needed to win them. Tactical forays on one front or another won’t be enough to ensure survival. Only a comprehensive commitment to a new operating model—a decentralized, adaptive structure that addresses current challenges and positions telcos to face future ones—can do that.

The migration has already begun at some companies. Telefónica’s move in September 2011 to reorganize itself and launch a U.K.-based digital unit is probably the most dramatic example. No company, however, is close to completing the transition.

For incumbents, the hurdles will be many. Top management must embrace the idea of running a portfolio of businesses, granting units a degree of autonomy while requiring them to be competitive within their subsectors—all under the watchful eyes of the financial markets. The stovepipe IT structures that still predominate at most telcos must be supplanted by systems based on open standards. A large and controversial workforce transition—involving staff reductions and outsourcing, as well as recruitment of new talent—will be unavoidable.

Indeed, it isn’t even possible to say with certainty where the journey will ultimately lead. Different configurations of businesses will make sense for different telcos. Deciding where to step up and where to step back will be top management’s most important responsibility in the next few years.

But, like it or not, a journey of one kind or another is unavoidable. One path is arduous, but it leads to a world where telcos can innovate more quickly, participate more fully in future services, roll out networks more effectively, and cut operating expenses significantly. The other path leads to obsolescence.